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Using Trading Envelopes, Trade Bands & Trading Channels

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... Trading with envelopes formed by bands around a moving average
(or around some similar indicator) is a well-known and effective
method of smoothing out short-term whipsaws common to most trend-following
systems. There are almost as many methods to use envelopes, as
there are technical traders. Most present-day software packages
provide the ability to display various forms of envelopes surrounding
a moving average.

There have been many internet based trading system software tests conducted which show
price channels are one of the most effective trading tools available.
Perhaps the most well known of these was a channel breakout study done
by Frank Hochheimer of Merrill Lynch® more than 10-years ago.
In addition to Hochheimer, there are many other well respected
commodity traders who
have seen the merits of channel trend trading. For example, although
best known for his work with moving averages, Richard Donchian
is also known for his channel trading using his 4-week rule.

Traders think channels and envelopes can be used in a variety of interesting
ways to serve as the foundation of a profitable trading system. Many such technical
indicators can be learned at a
commodity futures university and at other trader
educational centers, including
trade seminars. Keep in mind, it's extremely important for your trading success to
learn how to trade the market successfully and using a time-tested trading plan.

We will divide our discussion into 2-sections. The first will
deal with price bands which wrap or form envelopes around a moving average.
The second section will deal with channel-breakout systems.

Section One - Trading With Envelopes

Envelopes can be as simple or as sophisticated as you want to
make them. The simplest is a single moving average with a band
on either side calculated as a percentage of the moving average.
The area within the two bands theoretically acts as a buffer zone
that will tend to contain prices, especially if the underlying
market is in a trading range. The beginnings of a trend will normally
be indicated by a break outside of the bands. Trend corrections
or the end of the trend will see prices move back inside the bands
toward the moving average.

Another simple type of envelope is one that uses an absolute
point value on either side of a moving average. For example, a
10-day moving average in U.S. T-Bonds might be surrounded by bands
that represent 1-16/32nds points or $1,500. Normally this is the
risk the trader or money manager wishes to take in a trade in
any given market, rather than a specific point at which to enter
a trade.

The variations of the 2 types of trading envelopes described above
are almost infinite. For example, the moving average can be exponentially
or otherwise smoothed. Or, the percentage of prices contained by the bands can be varied for the long side versus
the short side, thus biasing the study in favor of increased volatility
in the direction of a trend.

Another trading possibility is using a moving average of recent highs and recent lows to define a trading envelope. The bands are intended to contain
and define the random price action of a trading range. Any breakout
beyond either of the bands should signal the beginning of a trend,
as prices are no longer wandering within the envelope.

A fairly recent and worthy addition to the ranks of channel studies
are Alpha-Beta bands and Bollinger Bands (named after John Bollinger,
technical analyst for the Financial News Network - FNN). Alpha-Beta
bands and Bollinger Bands are statistically defined bands around
a short-term moving average.

The PC software first calculates a simple moving average
and then calculates a moving standard deviation in parallel with
it using the same data series. Bollinger uses band two standard
deviations on either side of the moving average.

He explains how two standard deviations will theoretically contain
the vast majority of subsequent data. He also points out how the
bands rapidly expand and contract with market volatility, making
them very sensitive to recent market action.

Instead of there being two standard deviations away from the moving average,
the Alpha-Beta bands can be set at any increment of standard deviations
from the moving average. The usual setting for the Alpha-Beta
bands is only one standard deviation on either side of the moving
average.

The basic concept behind the statistically derived envelope widths
is that the volatility of the market being studied is what determines
the placement of bands. Using these self-adjusting bands means
that volatile markets will automatically have wide envelopes and
less volatile markets will have narrower envelopes.

General Envelope Trading Rules

There are almost as many possible-trading rules for envelopes
as there are rules for constructing them. The rules are, or should
be, based on the idea the envelope contains a significant amount
of the price movement of a market and that a move to or beyond
one of the bands is aberrant price behavior and should be acted
upon.

Traditional trading rules for envelopes are:

1. Enter market when a band is penetrated. This means that a
trend may be beginning.
2. Exit and reverse the position when the opposite band is penetrated.
(Use Closes)

1. Enter market when a band is penetrated. This means that a
trend may be beginning.
2. Exit the market when the same band is penetrated in the opposite
direction, or when the moving average between the bands is reached.

Both of these sets of rules ensure that a major trend will not
be missed. The first set of rules is basic and results in a pure
reversal system. We have an inherent skepticism about reversal
systems and prefer the second set of trading rules. In the second
set, the bands are also used for entry but the moving average
is used for exit.

If prices are within the bands after a trade is closed out, the
market is in a neutral zone and there will be no new trades until
there is a new breakout. Another reason we prefer the second set
of rules is because the theoretical risk on any one trade is reduced
to the distance between the band and the moving average instead
of the total distance from band to band.

"Optimum" Percentage for the Bands

The "correct" values for the moving average and the
surrounding envelope are elusive. The most extensive testing we've
seen covers the period from 1960 to 1978. It appears in an article
by Irwin and Uhrig in the December 1983 issue of Review of Research
in Futures Markets.

The authors used a breakout of the bands for entries and exited
when the moving average in the middle of the envelope was crossed.
(They used the second set of rules mentioned above.) They then
optimized for the best combinations (our usual caveats about optimizing
apply). Here are the numbers they found to be most profitable:

Commodity

Moving Average

% Band

Corn

45

3.2

Soybeans

20

4.0

Wheat

39

4.2

Sugar

36

4.8

Copper

39

1.0

Cocoa

43

6.2

Live Cattle

15

1.8

Live Hogs

10

2.1

Trading Within the Envelope

A technique we rarely see discussed involves using bands as
overbought/oversold indicators so that the trading takes place
within the bands instead of outside. We and other traders have
used this to great success when a market is in a trading range.
The trading rules are relatively obvious and simple. Buy when
the price hits the lower band. If the trade goes against you,
exit on a close below the lower band. Take profit and reverse
the position at the upper band, applying the same rules in reverse.

How do you know when the market is in a trading range and when
it's really trending? An objective method is to use an 18-day ADX. If
the ADX is rising, and/or if it's over 25, the market is trending
and you're better off using the trend-following envelope method.
If the ADX is falling and is below 25, trading within the envelope
can be very rewarding.

Section 2 - Trading Channel Breakouts

In addition to envelopes that are defined by distance from a
moving average, there are also channels that are defined by high
and low points over time. The simplest of these channel methods
is a pure reversal system, which is always in the market.

An upper band is formed by the high of the past 10-days, for
example. A lower band is formed by the low of the same number
of days, with the two bands forming a channel.

The channel will change in width as old highs or lows are dropped
and as new highs or lows are made. The system is long when the
upper band is penetrated, and stays long until the lower band
is penetrated, at which time the long is closed out and a short
position is assumed.

Donchian originally popularized this trading system in the 1960's
as the Weekly Rule. He used a four-week time frame, buying when
prices exceeded the four-week high, and selling when prices dropped
below the four-week low

Bruce Babcock published the results of his own test of the four-week
channel in his Dow Jones-Irwin Guide to Trading Systems. Babcock
found Donchian's method to be reasonably profitable over time,
although the drawdowns were pretty breathtaking.

As you might imagine, the risk at any given time can be sizable
depending on the size of the four-week range. In addition to the
risk on each position, the total portfolio risk would also be
very large because the system does not employ risk control stops.

It's worth pointing out, Bruce Babcock's testing results included
over $43,000 in losses on the S&P 500. This isn't unusual;
we and many other traders have found that the S&P behaves
differently than other futures markets.

The Tempus Formula, a very popular and expensive system marketed
in the 80's, was basically the same as Donchian's method except
that the time frames were optimized for each commodity. After
many years of profitable trading, the drawdowns in 1988 were so
severe that many users of the formula were forced to stop trading
it. In fairness to system, 1988 was a disaster for many trend
following methods.

Selecting the Time Values

What is the optimum number of days to use in constructing a
channel breakout system? Hochheimer's Merrill Lynch study we referred
to at the beginning of this article produced the following optimized
number of days for a good channel breakout system.

Commodity

#days

Commodity

#days

Cocoa

18

Soybean Meals

57

Corn

38

Wheat

22

Sugar

40

Pork Bellies

38

Cotton

70

Soybean Oil

42

Silver

4

Plywood

48

Copper

29

Hogs

8

Soybeans

51

Cattle

13

As you might expect with an optimized study, these channels proved
extremely profitable over the 6-year period of the test (1970-1976).
However, even with the benefit of optimization, only 42% of the
trades proved to be profitable. It should also be noted that the
drawdowns were very substantial and the 4-day channel in silver
produced 1,866 trades (more than one trade per business day).

It is easily possible to create a channel breakout system with
values optimized for each market, but in our experience these
systems break down fairly quickly. As (The Late) Bruce Babcock
has shown in his test of Donchian's method, a single number can
work and be profitable for a diversified portfolio. In fact, as
we pointed out, if the S&P were not part of the portfolio,
the system's profits were excellent.

William Gallacher, in his wonderfully written book Winner Takes
All: A Privateer's Guide to Commodity Trading, back tested a 10-day
breakout system on ten different commodities over a period of
130-weeks.

Trading results showed this simple 10-day channel produced profits
at a respectable rate of 24% annually. (By the way, we don't know
if Gallacher's book is still in print, but if you ever see it?
buy it. It's one of our all-time favorites!)

Markets were back-tested using a 10-day breakout system on 10 diverse
futures futures markets over a period of 130-weeks. The results
showed this simple 10-day channel produced profits at a respectable
rate of 24% annually. (By the way, we don't know if Gallacher's
book is still in print, but if you ever see it -- buy it. It's
one of our all-time favorites!)

Our research and experience with channel breakouts, which is
fairly extensive, shows 18-days to be a good number, which works
well in many commodities over long periods of time.

We're of the opinion almost anything in the range of 10 to 30-days
will be profitable over time. The drawdowns will be of different
sizes and occur at different times as numbers change.

Reducing the Risk with a Neutral Zone

A creative way to lessen the drawdowns inherent in channel-breakout
trading systems without giving up any profit potential was developed
by a money-manager of an acquaintance in Southern California. His system uses different time periods for entries and exits.
The exit bands for his method are one-half the time period of
the entry bands. For example, if the signal to buy soybeans is
a penetration of the high of the last 20-days, the inner channel
and exit point would be the low of the last 10-days.

This addition to the Donchian system has the advantage of drastically
reducing overall portfolio risk. It also takes away the pure reversal
nature of the trading-system by creating a neutral zone in which there
is no trading. This should have the effect of reducing whipsaws
in choppy markets as well as preserving more of the profits because
of quicker exits.